MoneyMonday: Buying, Renting, Refinancing

Welcome to this workshop, Buying, Renting, and Refinancing, tips and guidance for knowing when it is the right time to buy. I’m Janel Cross, one of your MoneyNav coaches.

If you’ve attended other sessions, you’ve been introduced to the three stages of financial wellness. If this is not familiar, look for the Money Milestones course which explores these stages in detail.

This session is a Stage 1, Financial Safety course.

Let’s start with a question… what is the best investment you’ve ever made… or if you asked a parent or grandparent, what would they say?

While you might hear things like, “saving in my 401k, investing in education” or “investing in the family” … the most common answer I hear is…

… buying a home which is often accompanied by a story of how they bought a home for $50,000 and sold it for $250,000. In fact, for generations, we have been conditioned to believe that buying a house is essential to achieving the American dream which is a very emotional way to frame what is, essentially, a financial transaction.

While there are good reasons to buy a house, both emotional and financial, our goal is to break this decision down into a set of pros and cons so you can make a decision that’s right for you.

First, I want to be clear that we don’t think renting is such a bad thing. Contrary to popular opinion, we do not believe that owning is a dream nor do we believe renting is throwing money out the window. Rather, we believe people should make wise financial decisions.

Consider these situations where renting makes more sense.

First, most of us can’t afford our dream home right away. So, it may be beneficial to rent while you save so you can buy a better “first home.”  

My dad told me the mortgage is the least expensive part of owning a home. I didn’t know what he meant then but I sure know now. Homeownership means maintenance and improvement. Homes in need of TLC can cost less initially but, unless you’ve got some DIY skills, you may wind up spending a lot of money to hire folks to do the work.  

Think about the cash flow of renting versus buying. While rental companies require two months’ rent and a security deposit, that’s probably less than the down payment you’d need for a mortgage. Also, rent payments often include things like utilities and trash which can make budgeting easier.

Maintenance and improvements are also necessary expenses for rental properties but the landlord, not you, will be the one who must manage those unexpected bills.

Finally, the size of your down payment impacts the cost of your mortgage. The less you put down, the more you’ll pay. So, better to rent longer and save more. But how will you know when you are ready to buy?

First, Is your income steady? A steady income ensures your home investment can be a long-term one. Also, a steady income is one of the things the lender considers in deciding whether you qualify for a mortgage.

Next (click), do NOT break your budget. Your mortgage payment should not exceed 25-35% of your monthly income. Remember, my dad’s advice. The mortgage payment is often the least of your home expenses.

Do you have an emergency savings account with 3-6 months’ worth of expenses? Remember, as a homeowner, when the air conditioner breaks in August, you, not the landlord, will be footing the bill.

Also, are you “credit-ready” to be a homeowner? Your credit score is a major factor in determining your mortgage interest rate. If you have debt or a below-average credit score, your interest rate and monthly payment will be higher.

Finally, are you emotionally ready for everything that comes with owning a home? Homeownership is a big responsibility and can lead to stress. Don’t get me wrong, there’s a lot of enjoyment too. But if you buy before you’re ready, the joy will be less, and the stress will be more.

This is the hierarchy of financial needs based on Maslow’s hierarchy of needs. The theory is we must tend to our basic needs first. The hierarchy gives you an idea of how to prioritize the seemingly endless demands for your dollars.

Notice that “goal-based savings” which includes saving for a home, is in the middle, as opposed to the bottom, of the pyramid. In other words, before you buy a home, you should have established savings accounts for emergencies and medical costs. You should also be saving in your employer’s retirement plan and have a plan in place to tackle high-interest debt.

If you check these things off the list first, it will go a long way to ensuring you are both emotionally and financially ready to take on a mortgage. Buying a home is a long-term investment. So, before you buy, consider how long you are planning to stay put. What is the likelihood a job change could require you to move? Or maybe you’ll start a family and need a bigger place.  

You spend money up front in a real estate investment, a lot of money. From down payments and closing costs to mortgage interest and taxes, in order to “make money” in a real estate transaction, you need to experience appreciation or an increase in value. And, like any investment, appreciation takes time. That’s especially true when it comes to real estate.

Our recommendation is that you should be nearly certain you’ll stay put for at least 7 years before you make a real estate purchase.

Owning a home is a big financial responsibility and making sure you can afford it is crucial. If the financial stars aren’t aligned yet, don’t worry. It’s better to rent longer than it is to jump into a mortgage too soon. Focus on living within your means. Create a budget to determine just how much of a payment you can afford. Our “Dollars and Sense” workshop can help you get started.

35% is the maximum portion of your monthly income you should spend on your mortgage payment. When you’re ready to start house hunting, you’ll want to get “pre-approved.” Keep in mind, lenders make more money on bigger loans. So, that pre-approval amount may very well be more than 35% and, therefore, beyond your means.

So, stay focused on your budget and what you can afford instead of getting emotionally drawn into the dream of a bigger house, a bigger mortgage, and bigger stress. Also, remember, there are several components of that monthly payment.

First is the re-payment of the purchase price, called the principal. then there is the interest you pay the bank. You’ll also pay property taxes and homeowners insurance. If you live in a community or a development, you might have monthly homeowners’ association fees. Finally, if you make a down payment of less than 20% of the purchase price, you will likely have to pay primary mortgage insurance or (PMI) as well.

Let’s look at how PMI affects your monthly payment and the total cost of your purchase.

In this example, let’s say the house costs $269k. The mortgage interest rate is 4.54% and a 20% down payment will cost almost $54k. The total monthly payment will include principal and interest expenses of $1095, $280 in taxes, and $79 for insurance.

If a 20% down payment is too much, you’ll have an additional cost added to your monthly payment for PMI because the lender considers you a higher risk if you can’t afford to invest as much in your down payment.

This first bar shows the monthly costs for a buyer that put 20% down. Their total payment is $1451.51.  

Let’s say you can only put 10%. The additional PMI will increase your monthly payment to over $1650.

And, if you can only put 5% down, your payment might be closer to $1725/month, almost $300 more than a borrower who does not have to pay PMI. And this extra cost has an even bigger impact on the total cost of paying off that mortgage.

For the borrower who put 20% down, it will cost them $523k to pay off that $269 mortgage over 30 years. But, as you can see, the cost of putting down less than 20% and paying that additional PMI cost adds up over time.

Before we move on, let’s consider sources of a down payment.

You may have a friend or family member willing to give you money to buy a home. Beware that most lenders will need to verify the source of the gift to confirm it’s not a loan you need to repay. For most people, the most likely source is personal savings.

Roth IRAs and 401(k)s also have homebuyer provisions. For example, if you’ve had your Roth IRA for at least 5 years and are buying your first home, you can withdraw a sum equal to the contributions you’ve made tax and penalty-free. For your 401k, you’ll need to check to see if your employer allows loans or distributions. You may also sell other assets you own to make your down payment.

Finally, there are programs available for first-time home buyers like student-loan forgiveness programs and FHA government-backed loans that allow you to buy a home with reduced financial requirements if you qualify.

Let’s talk about two more things that will impact the monthly and total cost of your mortgage, the length of the mortgage and your creditworthiness.

First, the sooner you promise to repay the bank, the less interest they will charge you. Here again, though, be sure you are sticking to the guideline of spending no more than 35% of your monthly income on the mortgage payment. In this example, we’ll consider a $400 home purchase and look at the differences between a 15year and a 30-year mortgage.

Because you have to repay the $400 over a shorter period of time, the 15-year mortgage will cost more per month. But the interest rate charged by the lender will be lower because they will get their money back sooner.

That means it will cost a lot less to pay back that $400k loan over 15 years than over 30 years even though the monthly payment is higher. It is important to understand the differences between being pre-qualified and pre-approved, which are two key steps in the mortgage application process.

Getting pre-qualified is informal and there is no obligation, whereas getting pre-approved is a formal commitment from the lender. When you get pre-qualified, you will get the maximum amount you can mortgage but once you are pre-approved you will have a specific purchase price and loan amount. Lastly, pre-qualifications are pending a final verification whereas pre-approvals are based on facts that are verified by documentation. Once your lender asks you for documentation to prove your income and finances, that is when you know you’re in the process of pre-approval.

As you can see, there are a lot of costs involved in buying a home and many additional costs involved in owning that home. There are also closing costs that are due at settlement to pay real estate agents, title agents, etc.

There’s also escrow which is a bucket in which you make monthly deposits that the lender then uses to pay taxes and insurance bills when they come due. Often, you have to make an initial investment for the full annual amount at closing time. You might also need to pay appraisal and inspection fees for the lender to approve the purchase. There may also be transfer taxes depending on your jurisdiction, and title insurance. It’s important to note, that closing costs can be substantial, typically ranging between $6 and %15k. And these costs are over and above your down payment.

As we wrap up, I’d like to make a comment on refinancing. As you probably know, mortgage interest rates change all the time. Over the 15 or 30 years of your mortgage, interest rates may drop below the rate you paid when you originally purchased your house. Or maybe your credit has improved, or you’ve made enough payments that you no longer have to pay PMI.

All of these may be reasons to consider refinancing your mortgage. Another reason folks consider re-financing their mortgage is to take cash out, which basically means giving part of your home back to the bank.

Let me explain what I mean by that…

When you do a “cash out” re-finance, the bank recalculates the terms of your loan including the balance you owe.

Let’s say you took out that $250,000 mortgage and you’ve made payments over a number of years and now owe $170,000. Let’s say you need $25,000 for home improvement so you decide to do a cash-out re-fi. That means your $170,000 balance owed will increase to $195,000 owed. You’ll also have to pay closing costs and interest to pay back that $25,000 loan.

If you’re doing home improvements or paying for education, that might be money well spent. But want I want to caution against is doing a cash-out refi to pay off bad debt like credit cards or auto loans. In the case of credit cards, unless you’ve also developed better cash management habits, you might find yourself back in credit card debt in a few years but with a higher mortgage balance.

When it comes to car loans, the closing costs you pay in the refinance may not be worth it since most auto loans are already at a pretty low-interest rate.

The last thing I’ll say about re-financing is to be sure to check with a financial advisor before you decide to move forward. Remember, there are closing costs involved in refinancing and closing costs benefit the bank, not you. Sure, lower interest is great, but you’ll have to spend money in order to save.

In many cases, you might be better off making additional payments on your existing loan. This can be a tricky calculation, but you can find online versions that will help. Then again, you can always schedule to meet with a MoneyNav coach instead. Finally, make sure you are going to stay in your home long enough for the refi costs to make sense. For example, if it costs you $8000 to refinance your loan and you only save $200/month in your payment, it will take you 40 months, or almost 4 years, to recoup your $8000 expense. And that’s assuming you paid the closing costs out of pocket as opposed to including them in the refinanced loan.

As we close out, here are some final thoughts as you consider this important, and long-term financial commitment.

If you are unmarried buyers purchasing a home together, whether a couple in a relationship or family members, be sure you discuss and plan for different scenarios. Who will be listed on the title? Who will be listed on the mortgage? Who is actually purchasing the home? What happens if someone wants to move? What happens if someone dies?

The Neighborhood Assistance Corporation of America, or NACA, has been around for a long time and is a great resource for first-time home buyers.

Be sure to negotiate. Ask the realtor if they will accept a flat rate to simply write an offer and contract if you have already found the house you want and are comfortable making the offer to the seller yourself. Also, shop around for both real estate agents and lenders.

Be aware of a buyer's versus seller’s market and the timing of purchasing a home and getting a loan. In a buyer’s market, there’s more inventory of homes on the market so prices tend to be lower. In a seller’s market, inventory is lower, or houses are selling faster so prices tend to be higher. The more you pay for a house, the longer it takes to realize that appreciation that makes the purchase a good investment. So, if you buy in a seller’s market, make sure you can make a good down payment and be as certain as you can that you’re going to stay in the house for a long time.

Finally, do everything you can to set yourself up for success. There’s a lot to love about home ownership. But my advice to most is this is, first and foremost, a lifestyle decision. Buying a home requires work and money. Those can lead to stress too. Take on a mortgage when you’re ready, not because you are worried, you’ll miss out on the American Dream.

This is a big financial decision. And like we suggest with all big decisions, just focus on the next best step. And if you don’t know what the next best step is, you can start with your MoneyNav assessment. This assessment takes about 5 minutes to complete and will result in a list of the next best steps that will be built into your personalized MyMoneyNav dashboard. You can also schedule to meet 1:1 with a MoneyNav coach. You can do that from your dashboard or simply email yourfinancialcoach@monynav.com.

Be sure to keep joining us for MoneyMondays. To view upcoming sessions and to sign up, visit www.moneynav.com/moneymonday. On behalf of the entire MoneyNav team, thanks for joining me! If you have questions on this topic or another, please reach out. We look forward to connecting with you.